While we have already covered everything you might want to know about startup funding, there is an important document that every entrepreneur should be aware of and that is the Term Sheet. When you approach the top angel investors so that they could fund your dream startup, you would be issued a term sheet.
The term sheet is extremely important for both entrepreneurs and investors. For entrepreneurs, it lays out all the things they must do or sacrifice to get what they want. For investors, while equity matters are simple, the term sheet lays down how much power in the company they would get for their money.
So while it may look like the entrepreneurs and the investors will be at loggerheads perennially, a term sheet has to be made in such a way that it is a win-win for both the parties. If you are a first-time entrepreneur and have never seen a term sheet before, you are at the right place. Let us see what a term sheet is in more detail.
What is a Term Sheet?
A term sheet is a summary of all the key terms of a transaction. Although it is non-binding in nature, it is bound by exclusivity and confidentiality. Basically, exclusivity binds you, the founder to particular investors for a certain amount of time. That prevents you from negotiating with other investors based on the terms of that transaction. Confidentiality bars you from disclosing the terms of the transaction with anyone else who has not signed them.
What Terms One Can Expect on a Term Sheet
Convertible Note
Convertible Notes are specified for early-stage startups with no valuation. This is like a loan which can be converted to equity later. In later stages, of course, investors get a part of the owner’s equity for the money that they put into the company.
Type of Stock
There are common shares and then there are preferred shares. Investors like to get preferred stock as it gives them certain privileges in terms of voting, liquidation etc.
Equity Dilution
Anti-dilution provisions are there for the investors. It protects their investments in case of a fresh round of funding at a lower valuation. The conversion price is readjusted and the more preferred stock is converted to common stock.
Tranche Investing
This implies that the investor shall provide the funding or cash in “tranches” or stages, depending on your company achieving certain pre-determined milestones. Although it is a great option for investors to reduce their risk, entrepreneurs should try to not include this in their terms as it creates a lot of stress and burden for everyone involved.
Right of First Refusal
As a startup founder, you should make sure that this is included in the term sheet both for yourself as well as the major investors as it allows you to reclaim shares being sold to a new party and thus avoid further division of ownership.
Investor Liquidation Priority
This term determines who gets what and how in the event of a liquidation. Generally, the preferred shares get paid before the common shares. Investors care about this a lot as this term enables them to get their full investment back or as much as possible in case of a loss. In case of a profit too, they want to be the first ones to claim their gains.
Pro-rata Rights
This gives investors the right to participate in future funding rounds. Investors want this option for themselves as they would want to know if their equity would get diluted in future rounds. It gives them the ability to continue their participation even if they might not actively want it since they took the risk of funding your startup in its initial stages.
Options Pool
These are the shares that are set aside to attract fresh talent. It depends on the hiring plan of the company and is typically around 7-10% of the company’s valuation.
Founder Vesting
Founder shares tend to have a vesting period of 3-4 years as nobody wants the founder to walk away with everything as soon as he gets all the shares. If you are an entrepreneur, you must see how the founder’s shares are being vested and ensure that you are protected in case of an acquisition.
Redemption Rights
Redemption rights allow the investors to make a redemption call. This term is generally not included in seed-round investing. It is great for investors who want to liquidate their interest in the company and then exit.
Right to Information
Investors get access to the premises and information of the company. The terms might dictate that they get to check annual statements and budget forecasts of the company and visit the company premises any time they want.
Board Composition
Investors sometimes demand a seat on the Board of Directors. As an entrepreneur, it would be wise to not have more than 2-3 investors on the board. That ensures the independence of decisions.
Registration Rights
When investors ask for registration rights, they want the right to resell the shares of the company. The company has to register the securities with the SEC. Registration rights can either be demand or piggy-back. Demand registration rights mean that the company initiates the registration of shares offered on demand by its investors. Piggyback registration rights enable the investors to have their shares included in a registration that the company is currently considering through a primary or secondary offering.
A Sample Term-Sheet Template
How to Ensure It’s Foolproof
The term-sheet is one of the most important documents for you and your investor. Getting it right shall be very beneficial for all the parties involved. So make it fool-proof and absolutely water-tight. How? Get proper legal advisors who know their job. Do not get random templates from random people online and try doing this on your own. You need to strike the perfect deal with your investor and a good legal advisor will help you do so.
Term sheets have a bad reputation among entrepreneurs for being overly complicated. If you are a seasoned entrepreneur, it would not be complicated for you because you would know the rules of the game. Problems arise for a first-time founder as you would then be up against some really smart and sophisticated investors. But experience smoothens things out. While investors definitely have to take care of their rights and their money, you must not forget that the term sheet protects your rights too. It also helps track your investment and keep your company on the right footing.
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